What if Recovery is Actually Bearish?

A few years back, top value investor Seth Klarman called this a “Twinkie” market — an unnatural concoction stuffed with artificial ingredients.

The twinkie manufacturers, of course, are the world’s central banks. Whenever things have looked terrible, the CBs stepped in with stimulus and jawboning. (Hence the ‘artificial ingredients.’)

The routine intervention of the Central Banks, plus the Greenspan Put transitioning to the Bernanke Put, have further led to an underscoring of the “bad news is good news” phenomenon, which in recent years has worked like this:

Good news is good news because things are getting better.

Mediocre news is good news because it means CBs keep rates near zero.

Bad news is good news because it increases the odds of more stimulus / more intervention.

As the senior Rothschild once said, “Permit me to issue and control the money of a nation, and I care not who makes its laws.” Those who recognized that the most powerful market and currency manipulator in all of human history (the Federal Reserve) was on their side, have used that knowledge to make a mint.

(A hat tip in particular to David Tepper, or as Dealbreaker calls him, “Big Tep,” who has exploited a keen awareness of central bank tendencies, coupled with a big-bet poker style of trading, to rake in many billions.)

But who pays for all this? Can the twinkie markets go on forever?

Isaac Asimov once had a science fiction story (don’t recall the name) about the discovery of a seemingly limitless energy source. Eventually it was revealed that, in keeping with the laws of physics, this seemingly limitless energy was actually being sucked out of an alternate universe (causing the inhabitants of that universe to die).

The theory of yours truly is that the seemingly magical gains created by twinkie markets, in keeping with the laws of market physics, are actually being sucked out of the “alternate universe” of the beleaguered middle class, through stealth inflation, increased debt leverage, and other long-term stagnation costs Joe Sixpack can’t even see. Kind of like using a wormhole to steal pennies and nickels, and eventually dimes and quarters and dollars, from the bank accounts of hundreds of millions, in such a way that they not only fail to notice, they have no way to comprehend what is happening even when explained to them.

A shift in the current landscape could have surprising consequences. What if a recovery is actually bearish for equities (and even more so for gold)?

Re, recovery prospects, let’s begin with some feel-good news stories. First there is this, via Reuters:

New U.S. single-family home sales surged in September to the highest level in nearly 2-1/2 years, further evidence the housing market recovery is gaining steam.

The Commerce Department said on Wednesday that new home sales increased 5.7 percent to a seasonally adjusted 389,000-unit annual rate — the fastest pace since April 2010, when sales were boosted by a tax credit for first-time home buyers.

Although sales in August were revised down to a 368,000-unit rate from the previously reported 373,000 units, the tenor of the report was relatively strong, with the median price of a new home rising 11.7 percent from a year ago.

The quickened pace in the housing sector is good news for the economy, but it remains one of the few bright spots.

“Housing is now a positive for the economy after years of being a drag, but it’s not enough to counteract the slowdown in manufacturing, which was the star,” said David Berson, chief economist at Nationwide Insurance in Columbus, Ohio…

Three decades after being devastated by the closing of steel mills, this gritty river valley is hoping its revival will come from cheap natural gas.

The hope doesn’t rest on drilling rigs, but on a multibillion-dollar chemical plant that Royal Dutch Shell PLC is considering building here because of a flood of domestically produced natural gas. Community leaders are touting the plant as the first step toward reviving a manufacturing industry many thought was gone for good.

“I never would have expected that as a region we’d have a second chance to be a real leader in American manufacturing,” Bill Flanagan of the Allegheny Conference on Community Development, a regional business group, told a crowd of locals who came to hear about the chemical plant. “Suddenly we’re back in the game.”

It isn’t just Beaver County reaping the benefits of cheap gas. Plunging prices have turned the U.S. into one of the most profitable places in the world to make chemicals and fertilizer, industries that use gas as both a feedstock and an energy source. And they have slashed costs for makers of energy-intensive products such as aluminum, steel and glass.

“The U.S. is now going to be the low-cost industrialized country for energy,” the energy economist Philip Verleger says. “This creates a base for stronger economic growth in the United States than the rest of the industrialized world.”

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Well how about that… some actual, genuine good news, rooted in the cheap energy possibilities of a manufacturing renaissance. Tapping good old American know how, on home American soil, via Uncle Sam’s emergence as the “Saudia Arabia” of shale plays.

The gist of the piece is that savvy energy traders with access to logistics are making a killing on the big spread between Brent crude and cheaper domestically produced WTIC crude. The lackluster price action in crude oil (see chart) is partially due to global slowdown, but also due to America’s surprise emergence as a heavy duty oil & gas producer (to a potentially far greater degree than ever before).

Back to the original idea though. Why would a recovery be bearish?

True story to illustrate the point: An old college buddy once told me about visiting a friend with a very health-conscious family. The mom of this family — they lived in a beautiful part of rural Oregon — was very disciplined in making sure her kids only ate the highest quality foods at home: Locally produced meats, vegetables and fruits, free of pesticides, preservatives, empty white sugar and flour etcetera.

My buddy and his friend were taking a break from college. They had both been on more or less a junk food diet (what do you expect from college students) for six to nine months.

And so, when they spent two weeks in Oregon eating the “good stuff” — food that was preservative and chemical free, nutritious, and healthy — guess what happened… it actually made them feel sick!

There is a reason why this occurs. When your body is hit with a barrage of grease, chemicals and other junk, it adjusts to the siege. The levels of garbage in your system are allowed to build up. You might not feel the greatest on a day-to-day basis, but your body adjusts and you feel “normal.”

Then, when you decide to get your dietary act together, something happens. Your body says “Great! Now we can flush out all this garbage!”

And so the poisons you had collected over months or even years start getting flushed out… and for a window of time, you actually go from “normal” to feeling like crap, as part of the adjustment process to a healthier state.

Similarly, if the market outlook for the U.S. economy is bright enough to warrant optimism, markets will have to “detox” from their current artificial-ingredient-laden, stimulus-sugar-addicted, central-bank-junk food state.

Just consider the follow-on implications, for example, in the event of a real (as opposed to central bank induced) recovery taking hold:

If it sounds absurdly counter-intuitive that a recovery could be bearish equities, just consider the impact of central banks as a counterbalance. Losing that counterbalance could tip the scales lower (in terms of equity prices) to a greater degree than organic improvement tips them higher.

For the past few years, the threat of economic stagnation (and deflationary downward spiral) was so severe, central banks overcompensated as a form of safety measure. But if we get signs of real recovery, they stop doing that.

And there is more…

In the depths of the crisis, and the immediate aftermath, corporate America overcompensated on the fat-trimming and cost-cutting side, using the financial crisis as political cover to make bone-deep cuts and ruthlessly pursue efficiencies they had never really tackled or previously put off.

But now those record profit margins are under threat… and a recovery could result in greater pain for corporate America — through central bank artificial stimulus withdrawal — than pleasure produced by consumer recovery.

Another analogy: After a serious accident, a patient spends two years in physical therapy, accompanied by some really good drugs. As a result of the drugs, and the intense PT, he is progressing nicely. Then one day the doc says “Great news! As of 2013, we’re taking you off the drugs.”

How is the guy going to feel? Well, he will still be recovering… the removal of the drugs is a positive marker for his recovering health… but for a time he is going to feel a lot worse…

Not only do markets have to contend with a “law of diminishing returns” as far as stimulus goes, they have to contend with the possibility that seeds of true recovery equal “stimulus never coming back”… true domestic economy resilience feeding rising long-term rates… and all this even as record corporate profit margins contract in an “off the drugs” environment where things are still improving, albeit slowly, as wages and costs start to uptick…

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And by the way: If a real recovery counts as bad news for equities, it could be downright terrible news for gold (and silver).

Again, signs of genuine recovery would lead to a “wall of worry” type environment — for the economy, not for stocks — with central bank stimulus withdrawal and anxiety over contracting corporate profit margins keeping irrational exuberance in check.

That isn’t the kind of backdrop against which gold and silver shine. If anything, it’s the kind of environment in which precious metals get stone-cold kicked to the curb.

We don’t mean to be overly down on precious metals. But signs of US recovery are completely antithetical to the precious metals bull case.

The last big upshot in gold came on the Federal Reserve’s “infinite QE” announcement. The follow-on implications of “infinite QE” were two-way bullish for gold — but door #3 not so much:

Door #3:What happens if we get weak-but-sustainable recovery at a limp-along pace?

In event of door #3, not only does gold look like a terrible investment, it starts to look like a massive short! (Silver too for that matter.)

Look, major league game changers don’t come along every day. In fact they come along almost never.

But the sheer size and scope of America’s shale potential (for oil and gas alike) counts as such a potential game changer… via foundation for manufacturing renaissance… as does the possibility that the asset side of America’s balance sheet (which we have discussed repeatedly) is hefty enough to comfortably withstand all the leverage demands placed upon it these past few years. (Attention debt doomers: You cannot look at debt — particularly long-term debt held by a global player of great strategic importance — in an asset vacuum!)

Nothing is guaranteed, of course. It’s wholly possible that America’s nascent recovery hits the skids… that the world falls into global recession in 2013… and that gold and secondarily equities are the place to be, once again, as central bankers panic into super-stimulus infinity and beyond, fueling some kind of mini-Zimbabwe scenario (in which paper assets go vertical as everything else turns to crap).

But given the potential sea changes we are seeing in housing, U.S. energy independence. consumer spending, and comparatively lackluster Europe / China outlook, it also remains quite possible that America’s energy-led recovery and Lazarus-like manufacturing rebound continue apace — developments which would be counterintuitively bearish equities, bearish treasuries and bearish gold, as the twinkie makers (central banks) steadily withdraw their heavy-handed artificial influence presence on all three…

In trading, mental flexibility is a foremost virtue. We humbly suggest that, as an alternative to getting locked in to a fixed view, one openly considers all plausible scenarios… thus demonstrating the fluid flexibility to surf the wave that presents itself (as opposed to one that never comes).